As economist Alvin Rabushka at the Hoover Institution has observed, "Critics of tax reform believe—with some justification—that the combination of a regressive payroll tax with a flat-rate income or sales tax would make the overall federal tax code more favorable to the wealthy. But a modification of the payroll tax, in conjunction with replacing the current, multibracket, complicated income tax with a flat tax or a sales tax, would represent a fair solution. A reduction in marginal income tax rates on wealthy households would be offset by higher Social Security taxes on them."
As for capital gains taxes, the subtle bifurcation of the word "capital" has always fascinated me as an economist. There is a great deal of economic theory that suggests, correctly I think, that reducing the tax burden on capital investment can have pro-growth effects. But this research emphatically refers to "capital" in the real, tangible, productive sense. It does not refer to fluctuations in the value of securities. I am all for significant tax credits for real capital investment and R&D, which would be passed on to shareholders as an increase in the returns to productive investment activities. But it is a stretch to use the economic research on real investment and quietly redefine "capital" as financial capital in order to reduce taxes on security price fluctuations. Wages are income. Capital gains are income.
Dividends are income too, but unless we want to perpetuate economic incentives that allow companies to report earnings and then squander excess retained earnings on speculative acquisitions and incentive compensation to insiders, dividends should only be taxed once. Simply put, dividends should be either deductible from corporate income and taxed as ordinary income, or they should be payable out of after-tax corporate income and then distributed as untaxed income at the individual level. If we want to provide tax credits for investment, and eliminate or reduce the tax on the sale or disposition of real physical capital that appreciates in value, that's fine too. But I frankly see no reason why income from securities is sacrosanct from a tax standpoint and the wages people earn are not.
Don't Take the Bait
Investors who allow Wall Street to convince them that stocks are generationally cheap at current levels are like trout - biting down on the enticing but illusory bait of operating earnings, unaware of the hook buried inside.
I continue to urge investors to have wide skepticism for valuation metrics built on forward operating earnings and other measures that implicitly require U.S. profit margins to sustain levels about 50% above their historical norms indefinitely. Forward operating earnings are Wall Street's estimates of next year's earnings, omitting a whole range of actual charges such as loan losses, bad investments, restructuring charges, and the like. The ratio of forward operating earnings to S&P 500 revenues is now higher than it has ever been. Based on historical data (see August 20, 2007 Long Term Evidence on the Fed Model and Forward Operating P/E Ratios), the profit margin assumptions built into forward operating earnings are well beyond two standard deviations above the long-run norm. This is largely because, as Bill Hester noted in his research article last week, forward operating earnings are heavily determined by extrapolating the most recent year-over-year growth rate for earnings. In the current instance, this is likely to overshoot reality, and in any event, has little to do with the long-term cash flows that investors can actually expect to receive over time.
I can't emphasize enough that when you hear an analyst say "stocks are cheap based on forward operating earnings" it would be best to replace that phrase in your head with "stocks are cheap based on Wall Street's extrapolative estimates of a misleading number."
More sober and historically reliable measures of market valuation create a much more challenging picture. Apart from our own measures, which indicate continued overvaluation, there are several good indicators of market valuation that are not overly sensitive to year-to-year fluctuations in profit margins. One is based on the 10-year average of actual net (not operating) earnings, which is advocated by economist Robert Shiller, and another is Tobin's "q" ratio which is based on comparing market value to replacement cost, and is advocated by Andrew Smithers. Both of these measures largely agree with our own measures, both presently and on a historical basis. Based on last week's valuations, both suggest that the S&P 500 is substantially overvalued.
